Real Estate Chronicle

A blog dedicated to real estate matters, finance as well as general economics and political economics issues. Posts written by Luigi Frascati, B.Econ. Your comments and suggestions are appreciated.

Friday, June 22, 2007

Real Estate And Personal Wealth

How the appreciation of real capital assets has redistributed household wealth.

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Much of Adam Smith's classic treatise on "The Wealth Of Nations" is not really about wealth at all, but about income. The two concepts are different: income is the flow of money a nation or household receives in a given lapse of time, say a year. Wealth, conversely, is the stock of capital assets the nation or household have accumulated over their lifetime, minus debts. The difference matters, but how much is hard to say.

On the one hand the distribution of income has been debated over and over but, on the other hand, the distribution of wealth has been largely ignored. This is so because whereas it is relatively simple to measure global income inequality, to measure wealth is an entirely different story. This is all the more true in this time and age, when the richest 10 percent of adults in the world own 85 percent of global household wealth, while the bottom half collectively owns barely 1 percent.

Even more strikingly, with the appreciation of real property assets particularly in Western nations, the average person in the top 10 percent of wealthy adults owns nearly 3,000 times the wealth of the average person in the bottom 10 percent.

In everyday conversation the term ‘wealth’ often signifies little more than ‘money income’. But the economic interpretation of wealth is much broader and encompasses the value of all household resources, both human and non-human, including the ownership of real capital. Although real capital is only one part of all personal resources, it is widely believed to have a disproportionate impact on household well-being and economic success, and more broadly on economic development and growth.

The World Institute For Development Economics Research (WIDER) in Helsinki has now attempted to measure personal wealth, which includes real estate, financial assets, consumer durables and even livestock. Specifically, estimates of wealth levels are based on household balance sheets and wealth survey data, which are available for 38 countries. These include many of the rich OECD countries, that is those nations members of the Organization For Economic Cooperation And Development, as well as the three most populous developing countries, China, India and Indonesia; so the data cover 56 percent of the world’s population and 80 percent of all household wealth.

The researchers at WIDER found that wealth levels vary widely across nations. Among the richest countries, mean wealth measured in US Dollars was $144,000 per person in the USA and $181,000 in Japan. Lower down among countries with wealth data are India, with per capita assets of $1,100, and Indonesia with $1,400 per capita. Even within the group of high-income OECD nations the range includes $37,000 for New Zealand, $50,000 for Denmark and $127,000 for the UK.

The regional pattern of asset holdings shows wealth to be heavily concentrated in North America, Europe, and high-income Asia-Pacific countries which together account for almost 90 percent of all global wealth. Although North America has only 6 percent of the world adult population, it accounts for 34 percent of household assets. Europe and high-income Asia-Pacific countries also own disproportionate amounts of wealth. In contrast, the overall share of wealth owned by people in Africa, China, India, Russia and other lower income countries in Asia is considerably less than their population share, sometimes by a factor of more than ten.

So, how wealthy are you compared to the rest of the world?

If you have more than $2,161 in net worth, defined as the overall value of your capital and financial assets minus debts, you belong to the wealthier half of the human race. If you are lucky enough to own more than $515,000, you belong to the top 1 percent of wealthy mankind, although this is hardly an exclusive club, since it contains 37 million adults just like yourself.

The top ranks are dominated by the Japanese, Americans and Europeans, in that order. China occupies the middle ground. Throughout the globe, wealth is shared much less equitably than income: more than one-half of it is held by just 2 percent of the world's adults. The distribution is equivalent to a world of ten people, in which one had $1,000 and the other nine had $1.00 each.

Furthermore, there are some appalling results as well. Many people in poor countries have next to nothing, but quite a lot of people in affluent countries have even less than that, since their liabilities exceed their assets (negative net worth). Take Sweden, for example: the bottom half of all Swedes have a collective net worth of less than zero. And this is a characteristic of pretty much all Nordic countries, due in large part to their social welfare set-up. Sweden, for example, has a wealth per head of $39,000 – less than South Korea.

Tuesday, June 19, 2007

2007: Mid-Year In Review

A retrospective look at 2007 reveals that, contrary to many year-end predictions and a few economic forecasts, Real Estate still rolls, Canada is still in one piece, America has not drowned into the worst recession since the disappearance of the dinosaurs and the Twelfth Imam has not landed from the Moon yet.

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Things seem to be moving in slow motion this year. We are all still alive and well, when in fact by now we should be all dead and buried - according to some prognostications I was reading all the way back in mid-December 2006, that is.

For the past few years the economies of North America have consistently defied the naysayers. Time and again the Cassandras who predicted trouble – whether a bubble explosion and the consequent crash of housing prices or the collapse in consumer spending followed by the crash of the American Dollar – were proven wrong. This year does not seem to be the exception, at least for now. Particularly the 'bubbleologists' – those individuals who have made the goal of their lives that of exploring the Milky Way with their economic telescopes looking for bubbles ready to collide with our planet – seem to be especially wrong.

To be sure, the housing boom has ended dragging down the pace of overall economic growth. But the housing 'correction' – as analysts are now beginning to call it – did not have calamitous consequences. In particular, we have not seen a recession in 2007 since – as I did anticipate at the end of 2006 – rather than slashing interest rates to stave off a slump, Central Banks both in the United States and Canada have focused more on inflation. Especially in the United States, after twenty-four months of steady interest-rate rises that have ultimately caught up with American serial borrowers, spending is now set to be a lot softer, which is a good thing overall. And the household saving rate, which in the last quarter of 2006 dipped to a negative 0.5 percent, has finally begun to inch up.

Even the so anticipated flood of defaults on mortgages and the consequent rise in loan delinquencies has failed to put a dent in the economy. Most household balance sheets are strong enough to withstand a drop in house prices. With consumer spending lower but not stagnant, overall economic growth this year is forecasted to be a little less than 2 percent for the United States and a little more than 2 percent in Canada – below its potential but not exactly a slump.

So, where does the foregoing scenario leave us and what can we reasonably expect the future to bring in the forthcoming months?

There is no question that 2007 is going to be a sluggish year, and a sluggish year is exactly what we need both to stem external imbalances and keep inflation under control. Allowing the economy to get an even footing through a slowdown of capital appreciation and at the same time allowing real wages to catch up is exactly the tonic needed for a healthy foundation. In general lines spending fuels consumption, which in turn erodes a limited quantity of resources. This is the concept behind inflation in an economy founded on scarcity of goods, which is typical of all capitalistic economies. As a direct and proximate result, therefore, controlling inflation is the key.

Core inflation, which excludes the volatile categories of food and fuel, is well above the 2 percent that Central Banks here in North America deem comfortable. Central Banks, therefore, will need to be extremely vigilant throughout the remainder of the year because the economy's natural 'speed limit' – defined as the rate of GDP growth that can be sustained without fuelling inflation – has slowed down. The two drivers that determine how fast an economy can safely grow – the number of employed workers and their overall productivity – are both flagging.

Unusually rapid productivity growth has been the source of economic strength in Real Estate over the past few years. But in 2006, as the stocks of unsold houses soared, builders cut back sharply after a multi-year construction binge. The pace of residential building fell by a fifth, enough to drag overall output down by one full percentage point. This year, conversely, the slump in construction has eased up already as builders have worked off a good portion of their excessive inventories. Adjusting to the shift in growth may not be easy for everyone, but absolutely necessary in order to avoid a recession.

And on the bright side of things, with growth strong in the rest of the world slower spending in North America can reduce the mammoth trade deficit without a serious dent in the overall global growth.

Monday, June 11, 2007

The Incredibly Shrinking Dollar

... and how it affects real estate consumers in North America.

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An exchange rate is the price at which the world demand for one currency equals the world supply of another currency. Foreign exchange rates are of particular concern to governments because changes in foreign exchange rates affect the value of products and financial instruments. As a result, unexpected or large changes can affect the health of nations' markets and financial systems. Variations in exchange rates also impact international investment flows, as well as export and import prices. These factors, in turn, can influence inflation and economic growth.

Interest-rate differentials between countries are one of the main factors that influence exchange rates. Money tends to flow into investments in countries with relatively high real (that is, inflation-adjusted) interest rates, increasing the demand for the currencies of these countries and thereby their value in the foreign exchange market. Price of oil, trade and the fiscal position and ratings of each country are also equally important.

The Greenback's tumble early on in the year to a 20-year low of $1.32 against the Euro was no surprise to many observers. In fact, now that the Dollar has continued to fall to its present rate of $1.35 for Є1.00, in retrospective the only real surprise was that it had not slipped sooner. And, furthermore, there are good reasons to expect the slide to continue.

The recent decline was triggered by nasty news about the American economy, paramount among which the fact that the housing markets' troubles are having a wider impact on the economy as a whole than originally anticipated and, second in line, the global imbalances that the American current account deficit has created. The U.S. current account deficit, which is mirrored by current account surpluses in Asia and in many oil-exporting countries, has grown to the point where the United States needs to attract 70 percent of the world's capital flows to finance its interest payments only - clearly an unsustainable situation. There are also mounting concerns that Central Banks in China and to a lesser extent in India, which have been piling up Dollars assiduously for years, may start selling.

Ben Shalom Bernanke, the Chairman of the Federal Reserve System, continues to sound unperturbed suggesting that the American economy will enjoy a soft landing, a statement which would lead to believe that interest rates are not going to undergo drastic cuts. This notion has underpinned the belief that the Dollar will hold up in the medium run, because foreign investors will remain eager to buy American assets and so finance the country's current account deficit. But if house prices continue to fall, the risk of a recession will grow and the enthusiasm of foreign investors for the Greenback will shrink.

Yet, despite all, the attractiveness of the American Dollar is based more on an illusion than anything else.

The main psychological reason for the strength of the Dollar has been the widespread belief that the American economy vastly outperformed the world other rich-country economies in recent years. This belief is now beginning to change among foreign investors, for a variety of reasons. First and foremost the figures do not support the hype. For instance, it is true that America's GDP growth has been faster than Europe's, but that is mostly because America's population has grown more quickly. In fact, in real terms productivity growth over the past decade has been almost the same in the Euro Zone as it has been in America.

So therefore, contrary to the popular perception, the American economy has not significantly outperformed Europe's in recent year. But to achieve this not much better than parity status, the United States has incurred a huge current account deficits, while household savings have plummeted to a record low. Over the same period, the Euro-area economies saw no fiscal stimulus and household savings barely budged.

America's growth has been driven by consumer spending. That spending, supported by dwindling saving and increased borrowing, is clearly unsustainable and the consequent economic and financial imbalances must be inevitably unwind. As that happens, the country could face a prolonged period of slower growth that could spill across the border and affect America's single biggest trading partner as well: Canada.

In light of the foregoing, then, how should American and Canadian real estate consumers react?

Two countervailing factors tend to support the Dollar. First, emerging economies - especially China and India - hold so many Greenbacks that they fear the capital loss that they would incur if they encouraged the Dollar to drop. Second, emerging economies have all the interest to keep the value of their own currencies down to help their exports. As much as China and India have done giant leapfrogs forward in both manufacturing and finance - and in this respect both countries deserve the praise of the international community - neither has been able to fully create a domestic economic section of consumers that can absorb in whole or even in noticeable part what they produce. Besides, many a firm located overseas are American or branches or sub-branches of American multi-national corporations, and their ultimate goal is to produce output cheaply for export into North America.

Seen in this light, that talk of the weakness of the American Dollar is vastly exaggerated. In fact, the Federal Reserve reports that the real trade-weighted exchange rate of the Greenback against a broad basket of currencies is still close to the 30-year average. In other words, the Dollar needs to fall a lot more to make a dent in America's external deficit.

Moreover a falling Dollar does not necessarily spell doom for American consumers. In fact, all of us in North America could well benefit from a gradual slide in the American currency, as the ultimate result would be to shift production back into America's tradable sector, thus cushioning the domestic economy. A weaker Dollar would tend to hurt exporters in Europe and Asia and benefit those in North America as goods made here would become far more competitive abroad, thus spurring capital in-flow into the continent, as well as both foreign and domestic consumption.

Hence, so long as interest rates remain stable, real estate consumers both in Canada and in the United States need not to be overly concerned with the drop in value of the Greenback.

Tuesday, June 05, 2007

Let's Play Monopoly

Last year’s acquisition by The Blackstone Group (www.blackstone.com) of Equity Office Property Trust for USD 36 billion was the largest buy-out ever of an owner of office buildings. More importantly, it signaled that the commercial property market is healthy, now more than ever, and that is not afflicted by the same ailments so characteristic of the residential markets, much less by bubbles of any color, shape or form.

Albeit the biggest deal ever, Blackstone’s move was one of the many transactions leading to the privatization of the commercial property markets, a trend that since then has seen some USD 100 billion change hands and disappear from public ownership both in the United States and Canada. Today’s property barons can borrow against the value of the assets and use the cash-flow from rental income to meet the interest payments. With property values rising fast, they can afford to strike any deal they want.

This Monopoly-like craze is not confined to America. Just as bonds, stocks and shares are freely traded across borders, so is ownership of commercial property assets. Monopoly goes global!

The Bank of Canada reports, for example, that cross-border commercial and office property investment worldwide hit USD 290 billion in the first half of 2006 – a 30 percent increase over the same period in 2005. In the process, once obscure markets have been swept into the mainstream. Take the Euro Zone, for instance. Practically all new entrants into the European Union have benefited from the convergence of Western investors looking to snatch up buildings at rock-bottom prices. Bulgaria is the latest example of this trend.

Commercial real estate is all part of the same ‘search for yield’ trend that has seen investors hunting around the globe for other high-income assets. It is all part of globalization and governments – especially Western governments – see it in a positive light. Because of this the gap between yields on the highest-quality properties and the second-tier sites, especially those located in what used to be second-tier nations, has narrowed everywhere.

Commercial property is a hybrid asset. It offers high yield, giving it bond-like characteristics. And moreover like shares and unlike bonds, investors can expect that yield to grow, at least in line with inflation. Enthusiasm for the sector waned in the 1980’s and 1990’s because of fat Stock Market returns. In this day and age, however, pension funds are desperate to diversify from shares and bonds, and commercial property is benefiting from capital being diverted by investors from the Stock Exchange.

Not everything is rosy, though. The catch is the lack of liquidity. It takes time and know-how to buy and sell a building, especially in farfetched places, and recruiting and managing tenants as well as maintaining and up-keeping those buildings involves an organization all by itself. So as the market develops, investing becomes more and more sophisticated.

The key to the growth of the commercial property markets and their widespread globalization has been the ever-increasing development of REIT’s or Real Estate Investment Trusts. These are companies quoted in the Stock Market that bundle together portfolios of buildings, allowing investors to buy and sell whenever and wherever they wish.

Saturday, June 02, 2007

Sticky Deals

As markets are decelerating, there is an anxious face-off between sellers and buyers of real capital assets as expectations of big profits fade away just as well.

In economic terms, the slowdown that we are witnessing today in many real estate markets is actually welcome news since allowing the economy to cool off through a reversal of real capital appreciation while at the same time allowing real wages to catch up is exactly the tonic needed to consolidate market wealth achieved thus far, eliminate the 'froth' by reducing speculation and, in ultimate analysis, keep bubbles away.

But then, of course, not all of us are economists - at least not my own clients.

The house party had to end eventually, even if many sellers still refuse to believe it. In fact many sellers remain defiant to the point of delusion, demanding one more drink at the housing bar. ‘Stickiness' is a noun used in Economics to describe a situation in which a variable is resistant to change. Price stickiness, therefore, reflects the fact that asking prices of interests in land remain high and even increase at a time when demand lowers.

Sales of existing homes, both new and resale, are down 7 percent and 6.6 percent nationwide respectively in the United States and Canada in the first quarter of 2007 compared to one year ago. Buyers are taking their time, leery of overpaying and taking on too much debt, and yet particularly in the United States the National Association of Realtors reports that in the first quarter of this year listing prices of single-family detached units not only failed to match the decline in demand, but in fact in eighty-two metropolitan areas they actually increased compared to a year ago.

Experts in market psychology say stubborn sellers suffer of a classic case of denial. When it comes to financial-making behaviour, people would rather gamble and hope that prices come back. They tend to ignore information suggesting that prices are dropping. It is the same mentality that leads blackjack players to double down in a losing streak. This explains sellers' reluctance to cut down prices, and in fact several academic studies also suggest that frustrated sellers take their homes off the market rather than accepting lowball offers. Conversely, when investors see prices rise they get overconfident - much like the hot-hand bias that leads folks to think a basketball player will sink his fourth shot after making the prior three, even though probability says the odds are the same for every shot.

Price stability certainly is the utmost desire of central bankers, in any market. In fact, many a central bank have it, more or less. Consumer-price inflation hovers to 2 percent in America, 2.2 percent in Canada, 1.6 percent in the Euro Zone and 0.6 percent in Japan. One might argue, therefore, that because the overall price level is not changing a lot, nor are individual prices - but this is not necessarily a rule of thumb.

How often prices move is an important question. Shifts in prices are like the traffic lights of an economy, signalling to people to buy more of this and less of that, to spend or to save, or to find new jobs. If the lights change readily, resources can be redirected smoothly. If they get stuck, so does the economy. In particular, if neither prices nor wages shift easily, the cost in output and jobs and, ultimately, the cost of reducing inflation can be high. Sticky prices also mean that an inflationary shock - an increase in oil prices, for instance, like the one that is happening this very moment - can take a long time to work its way through the system.

Price stickiness in any market, but especially in a big-ticket market such as Real Estate, is responsible for and reflects some confusion that exists between nominal and real values and gives rise, moreover, to a particular phenomenon known as the ‘Money Illusion'. Money illusion does influence people perceptions of outcomes. Experiments have shown that people generally perceive a 2 percent cut in nominal income as unfair, but see a 2 percent rise in nominal income where there is 4 percent inflation as fair, despite the fact that the two situations are almost rational equivalents. The same happens in Real Estate, where the trend is for asking prices to remain high or even increase when selling prices are dropping.